Thursday, March 12, 2009

What is the best analogy to help us understand the financial crisis?

In attempting to understand the current financial crisis I don’t have the benefit of a great deal of knowledge of macroeconomics. Nevertheless, I can understand only too well what many macroeconomists are saying about fiscal stimulus and multipliers because they are using Keynesian language that I learned in my first year at university 45 years ago.

During the 1970s nearly all macroeconomists seemed to abandon the crude Keynesianism that I learned about at university. Why have so many reverted to it at this time? The answer might have more to do with the desire for a comfort blanket in times of uncertainty than with the merits of Keynes’ approach. The Keynesian remedy does not seem to me to be much more relevant to the current situation than it was to the stagflation of the 1970s. It suggests that when you wake up with a debt-induced hangover, then you will soon feel better if you get the government to take on some more debt on your behalf. That doesn’t sound to me like a recipe for a more healthy world economy.

So I have been looking for articles which will help me to understand why the world is in recession and what can be done about it. The best aid to understanding that I have found so far is John Cochrane’s refinery analogy:

“Imagine by analogy that several major refineries had blown up. There would be tankers full of oil sitting in the harbor, and oil prices would be low, yet little gasoline would be available and gas prices would be high. Stimulating people to drive around would not revive gas sales. Borrowing gasoline and using it on infrastructure projects would be worse. The right policy action would obviously be to run whatever government or military refineries could be cobbled together on short notice at full speed, and focus on rebuilding the private ones.” John H Cochrane, ‘Fiscal Stimulus, Fiscal Inflation or Fiscal Fallacies’.

The “major refineries” correspond to the banks that have loaded themselves with toxic assets. The oil tankers sitting in the harbour correspond to the savings that are going to government securities paying low interest rates and the high gas prices correspond to the high price of credit to businesses and consumers (in many countries). The running of government and military refineries at full speed corresponds to the government raising funds by issuing debt and lending it to businesses and consumers.

Cochrane recognizes that this analogy does not give a complete picture of the current situation. He explains that if we just had a shock to the supply of credit (blown up refineries) we would expect to see stagflation – lower quantities of goods and services sold, but upward pressure on prices. Instead we are seeing lower quantities sold and lower inflation. So, we are also seeing a demand shock as a result of people becoming much more averse to holding risks. (The refinery analogy could possibly be stretched to accommodate this. If several major refineries were blown up then investors could be expected to seek to reduce the exposure of their portfolios to other firms that might also be at risk of “blowing up”.)

Would the situation be resolved if the central banks were to target a specific rate of growth in nominal GDP (as I discussed in an earlier post)? The answer might depend on what assets the central banks purchase from the public in pursuit of this objective. If they buy government bonds this will help satisfy the increased demand for money, but not address the supply shock in the credit market. It is possible that the market could take care of this problem e.g. major firms may be able to by-pass the damaged banks by raising funds directly from the public. However, when central banks buy newly-issued commercial paper and securitized debt they are acting directly in place of the injured banks.

As a stop-gap measure this kind of by-pass intervention has the important merit of being a lot easier to unwind than alternative approaches. If central banks confine their purchases to quality assets they will not have any difficulty selling them when inflation begins to rise and people get tired of holding so much money. The effects of fiscal stimulus involving cash splashes by governments are likely to be much more difficult to unwind without a decade or more of high-tax and low-growth stagflation.

It seems to me that current debates about the effectiveness of stimulus packages in lifting aggregate demand tend to miss a more important point about consequences beyond the immediate short term (i.e. long before Keynes’ long run when we will all be dead). John Cochrane makes the point as follows in relation to the U.S. economy:

“If the resources are not there to unwind our current operations, to quickly retire ... newly created debt, a large inflation will result as people dump government debt. If history is any guide, this outcome will unleash economic dislocations on a scale to make our current troubles look like a pleasant memory.”

4 comments:

Just found your blog - you commented on a post of mine in a discussion over at blogcatalog.

I like you welcome message. It makes sense to me.

So (assuming I understand your post) you disagree with the stimulus package approach.

Since the private sector is not spending doesn't that force the government to spend since we need something flowing. Also, infrastructure sounds good to me. Is that not one of the big differences between third world and the developed world?

I noticed you described yourself as a retired economist. I think some might wonder how that could be since economist never work.

I do disagree with stimulus packages that involve governments taking on more debt to give money to people in the hope they will spend it. Increased infrastructure spending may make sense, but not on roads to nowhere. Perhaps there should be a special tax on engineers who like dark beer and Eric Clapton music to help fund infrastructure projects. (See I do have got a sense of humour!)

I agree "we need something flowing". What we need to get flowing is credit to the private sector. In the short term this means by-passing the banks e.g. by buying up corporate bonds. In the longer term the banks need to go through some kind of restructuring process. I suppose that is what Ben B of the Fed is talking about.

So, if we are lucky we might end up with a re-run of the stagflation to the 1970s rather than the simple stagnation that Japan has experienced since the early '90s. (That's an economist's joke!)

By the way, it is just an engineers fallacy that infrastructure is "one of the big differences between third world and developed world". Attempts to promote economic growth in the third world in 1950s and '60s through infrastructure spending were not a great success. Investment in infrastructure is just one of many important elements in the growth process (and most infrastructure investment doesn't have to be undertaken by governments).

However, the world would be a better place if finacial engineers were as trustworthy as ordinary engineers.

I'm not familiar with the 50's and 60's infrastructure spending projects.

I agree it takes than building stuff for the sake of building stuff.

Thinking of Japan - are there any lessons from the US rebuilding Japan after WW2? Back when this just-in-time idea was being really hyped up at work, we had some lessons on it and the background of it was related to our rebuilding Japan. I think that was a success (for Japan and maybe us too).

I think the key to success in Japan from the end of WW2 to the early '90s was a relatively high level of economic freedom - at least by comparison with other countries with a similar level of development at that time. Japanese firms could invest in export industries with a reasonable expectation that the returns would not be siphoned off by government officials, taxes, import quotas, union bullying etc.

It seems to me that the key to Japan's relatively poor performance since the early '90s is in its policy response to its financial crisis i.e. the focus on increasing government spending, rather than allowing the market to work in the financial sector (to restructure or replace the injured banks) and adopting a monetary and exchange rate policy that would encourage the private sector to invest.

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